10-Q 1 a72293e10-q.txt FORM 10-Q MARCH 31, 2001 1 U.S. SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 --------------------------------------- FORM 10-Q (Mark One) [X] Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended March 31, 2001 [ ] Transition report pursuant to Section 13 or 15(d) of the Exchange Act. For the transition period from ___________ to ___________ Commission File Number: 0-21975 ECO SOIL SYSTEMS, INC. (Exact Name of Registrant as Specified in its Charter) NEBRASKA 47-0709577 ---------- ------------ (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification No.) 10740 THORNMINT ROAD SAN DIEGO, CALIFORNIA 92127 (Address, Including Zip Code, of Principal Executive Offices) (858) 675-1660 (Registrant's Telephone Number, Including Area Code) Check whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES X NO ------- ------- State the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date: As of May 4, 2001, 19,681,464 shares of the Registrant's Common Stock, $.005 par value per share, were outstanding. 2 INDEX ECO SOIL SYSTEMS, INC. FORM 10-Q

2 3 ECO SOIL SYSTEMS, INC. CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AMOUNTS)

See accompanying notes. Note: The Balance Sheet at December 31, 2000 is derived from the audited financial statements at that date, but does not include all of the disclosures required by generally accepted accounting principles. 3 4 ECO SOIL SYSTEMS, INC. UNAUDITED CONSOLIDATED STATEMENT OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

See accompanying notes. 4 5 ECO SOIL SYSTEMS, INC. UNAUDITED CONSOLIDATED STATEMENT OF CASH FLOWS (IN THOUSANDS)

See accompanying notes. 5 6 ECO SOIL SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. BASIS OF PRESENTATION The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of Eco Soil Systems, Inc. (the "Company"), all adjustments, consisting only of normal recurring adjustments, necessary for the fair statement of the results for the three-month periods ended March 31, 2001 and 2000 have been made. The results of operations for the three-month period ended March 31, 2001 are not necessarily indicative of the results to be expected for the full fiscal year. For further information, refer to the audited financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2000. 2. NET LOSS PER SHARE In accordance with Financial Accounting Standards Board Statement No. 128, "Earnings per share" ("SFAS 128"), basic earnings per share is calculated by dividing net income by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution of securities that could share in the earnings of the Company such as common stock which may be issuable upon exercise of outstanding stock options and warrants and conversion of debt. These shares are excluded when their effects are antidilutive. 3. DISCONTINUED OPERATIONS On July 28, 2000, the Company completed the sale of substantially all of the assets of its Turf Partners subsidiary (the "Asset Sale") to the J.R. Simplot Company ("Simplot") and as a result, the March 2000 financials have been retroactively restated to give effect to the discontinued segment. At the closing of the Asset Sale, Simplot made a cash payment of $23 million and assumed Turf Partners' existing long-term debt and vendor payables totaling $37.3 million. Simplot also assumed Turf Partners' outstanding contracts and leases. The Asset Sale was consummated pursuant to an Amended and Restated Asset Purchase Agreement dated April 5, 2000, as amended by a First Amendment to Amended and Restated Asset Purchase Agreement dated June 9, 2000. The unaudited results of the discontinued operations (in thousands) were as follows:

6 7 For the periods presented, the Company borrowed funds from institutional lenders and accredited investors to provide working capital for the parent company and its subsidiaries. The interest expense associated with this debt was originally recorded by the parent company, but a portion of interest expense associate with this debt has been allocated to the discontinued operations noted above. Interest expense allocated to the discontinued operations totaled $789,000 for the three months ended March 31, 2000. Also, selling, general and administrative expenses that were recorded by the parent company but were specifically an expense of the discontinued operations have been allocated to the discontinued operations as shown above. The amount of selling, general and administrative expenses allocated by the parent company to the discontinued operations totaled $425,000 for the three months ended March 31, 2000. The historical consolidated balance sheets reflect the assets and liabilities of discontinued operations as current or non-current assets based on the original classification of the accounts, except that current liabilities are netted against current assets and non-current liabilities are netted against non-current assets. 4. SEGMENT INFORMATION For purposes of analyzing and understanding the financial statements, the Company's continuing operations have been classified into the following business segments: Proprietary: This segment enters into contracts with golf courses, turf maintenance service businesses and agricultural growers, or distributors that sell to those end-user markets to manage the health and productivity of their soil during their respective type of season. The contracts require the Company to perform a comprehensive soil analysis at the beginning of the season, develop a treatment regimen, install the Company's proprietary BioJect system at the customer's site and provide the microbials throughout the season. Distributed: This segment distributes a wide range of irrigation and other agricultural supplies to growers. The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies. The Company allocates resources and evaluates the performance of segments based on net profit or loss.

Depreciation that is separately identified to proprietary and distributed segments are charged to those segments. All other general and administrative costs are recognized by corporate. Foreign assets are included in segment assets. 7 8 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Certain statements contained in this Management's Discussion and Analysis that are not related to historical results are forward-looking statements. Actual results may differ materially from those projected or implied in the forward-looking statements. Further, certain forward-looking statements are based upon assumptions of future events, which may not prove to be accurate. These forward-looking statements involve risks and uncertainties including but not limited to those referred to in "Item 5. Other Information. Factors That Could Affect Future Performance." This information should be read in conjunction with the financial statements and notes thereto included in Item 1 of this report for the quarter ended March 31, 2001 and 2000. Additionally, the financial statements and notes thereto and Management's Discussion and Analysis in the Company's Annual Report on Form 10-K for the year ended December 31, 2000 will provide additional information. OVERVIEW The Company develops, markets and sells proprietary biological products, and their delivery systems, for the golf and agricultural industries. The Company's most unique delivery system is the BioJect, a patented and EPA-approved device that stimulates and dispenses biological products through irrigation systems. The Company's proprietary products are sold both directly and through traditional distribution channels into the turf market and through direct sales along with irrigation products into the agricultural market. On July 28, 2000, the Company completed the sale of substantially all of the assets of its Turf Partners subsidiary (the "Asset Sale") to the Simplot Company ("Simplot"). At the closing of the Asset Sale, Simplot made a cash payment of $23 million and assumed Turf Partners' exiting long-term debt and vendor payables totaling $37.3 million. Simplot also assumed Turf Partners' outstanding contracts and leases. The Asset Sale was consummated pursuant to an Amended and Restated Asset Purchase Agreement dated April 5, 2000, as amended by a First Amendment to Amended and Restated Asset Purchase Agreement dated June 9, 2000. In connection with the Asset Sale, the Company entered into two distribution agreements with Simplot. In the first agreement, a Distribution and License Agreement, Simplot agreed to purchase and distribute a minimum of $5 million of the Company's proprietary FreshPack(TM) products during the first two years of the five-year agreement. In the second agreement, Simplot agreed to distribute the Company's proprietary products in Simplot's Soilbuilders stores. The Company and Simplot also entered into a field trials agreement pursuant to which Simplot will pay the Company to perform Field Trials of the Company's BioJect system and microbials on selected Simplot crops in 2001. Following the Asset Sale, the Company began invoicing the BioJect customers directly and paying a commission to the Simplot salesmen for renewed microbial and service contracts and the sale of BioJect system units. FIRST QUARTER ENDED MARCH 31, 2001 COMPARED TO FIRST QUARTER ENDED MARCH 31, 2000 RESULTS OF OPERATIONS REVENUES For the first quarter of 2001, our revenues were $5.7 million, a decrease of 17.4% versus $6.9 million for the first quarter of 2000. The decrease in revenues is primarily due to the decrease in distributed revenues. For the first quarter of 2001, proprietary revenues were $1.8 million, a decrease of 8.7% versus $1.9 million for the first quarter of 2000. The decrease was due to the inclement weather in the Midwest and East, which delayed the orders of products such as FreshPack(TM) and primarily the start-up of the BioJect system units for the season. However, the overall decrease was mitigated by sales of the RhizUp(TM) product, which increased by $457,000 or 93.5% compared to first quarter of 2000. Distributed revenues were $3.9 million, a decrease of 20.8% versus $4.9 million for the first quarter of 2000. The decrease in distributed revenues is due to the closing of five unprofitable stores that were operated by the Company's Agricultural Supply subsidiary. 8 9 GROSS PROFIT For the first quarter of 2001, our gross profit was $1.2 million, a decrease of 40.5% versus $1.9 million for the first quarter of 2000. For the first quarter of 2001, our gross margin was 20.4% versus 28.3% for the first quarter of 2000. The decrease in gross margin resulted primarily from decreased distributed products margin, which was negatively impacted by the liquidity problems of the Company that prohibited the taking of cash and volume purchase discounts and rebates. SELLING, GENERAL AND ADMINISTRATIVE EXPENSE For the first quarter 2001, selling, general and administrative ("SG&A") expense was $3.4 million, a decrease of 11.4% versus $3.9 million for the first quarter of 2000. SG&A expense as a percentage of revenues was 60.4% for the first quarter 2001 compared to 56.4% for the first quarter 2000. The decrease in the SG&A is primarily due to the overall cost control efforts employed by the Company and the restructuring actions taken by the Company in the second quarter of 2000. As part of these actions, the Company closed five unprofitable stores and eliminated redundant positions within the Company. Also, in the first quarter of 2001, the Company included in SG&A a non-recurring charge of $209,000 related to the accelerated vesting of stock options granted to former employees. RESEARCH AND DEVELOPMENT For the first quarter of 2001, research and development ("R&D") expense was $37,000, compared to $114,000 for the first quarter of 2000. The decrease in R&D expense is due to the Company being continually more selective in the R&D programs that are being supported. AMORTIZATION EXPENSE For the first quarter of 2001, amortization expense was $133,000, compared to $141,000 for the first quarter of 2000. INTEREST EXPENSE For the first quarter 2001, interest expense was $923,000, an increase of 5.2% versus $877,000 for the first quarter 2000. The increase is due to additional non-recurring debt issuance costs of $581,000 related to the convertible debentures. NET LOSS FROM CONTINUING OPERATIONS For the first quarter of 2001, net loss was $3.3 million or $0.17 per share compared to a net loss of $3.0 million or $0.16 per share for the first quarter of 2000. LIQUIDITY AND CAPITAL RESOURCES We have financed our operations since inception from revenues from sales of our products, sales of our common stock, borrowings from our principal shareholders and debt financing. For the first quarter of 2001, our operating and investing activities used cash of $683,000. On August 25, 1998, the Company issued an aggregate of $15 million principal amount of the Company's Senior Subordinated Notes due 2003 (the "Notes") to two lenders. On July 28, 2000, the Company retired $14 million of the Notes from the proceeds of the Asset Sale. Also, the Company amended the Note and Warrant Purchase Agreements with the Lenders to eliminate financial covenants. The Company replaced the Notes with amended Senior Subordinated Notes (the "Amended Notes") with an aggregate principal amount of $1.4 million covering the principal and accrued interest of the Notes not paid on July 28, 2000. The Amended Notes bear interest at an annual rate of 14% and are due on January 28, 2002. Monthly payments of $87,000 in the 9 10 aggregate began on August 28, 2000. As a result of the retirement, the Company wrote-off $3.8 million of unamortized debt issuance costs associated with the Notes. On June 30, 1999, our Turf Partners subsidiary entered into a credit agreement with Coast Business Credit (the "Coast Working Capital Facility"). The Coast Working Capital Facility was a $25 million three-year credit facility based upon Turf Partners' eligible inventory and receivables and has an interest rate of prime rate plus 1.00%. On July 2, 1999 the Company drew down on the facility and paid all amounts due under and terminated a line of credit with Imperial Bank. On July 28, 2000 at the closing of the Asset Sale the Coast Business Credit working capital facility was assumed by Simplot. On June 30, 1999 the Company's wholly owned subsidiary Agricultural Supply, Inc. entered into a credit agreement with First National Bank (the "FNB Working Capital Facility"). The FNB Working Capital Facility is a $10 million three-year credit facility based upon Agricultural Supply's eligible inventory and receivables and has an interest rate of prime plus .25%. Effective June 1, 2000, the following changes were made to the terms of the FNB Working Capital Facility: (a) fixed assets (BioJect system units) were added to the description of collateral, (b) maturity date changed to December 31, 2000, (c) interest rate was changed to Prime plus 1.5%, and (d) personal guarantees were provided by key executives. As of December 31, 2000, of the $6.5 million availability (based on eligible receivables, inventory and fixed assets) under the FNB Working Capital Facility, Agricultural Supply had borrowed $5.2 million. On March 21, 2001 the Company entered into a Change in Terms Agreement with FNB that extended the working capital facility to March 31, 2001 and waived the covenant violations as of December 31, 2000. The Change in Terms Agreement further prohibits the Company from making any payments to subordinated debt holders, thereby putting the Company in default with the Debentures (discussed below) and the Amended Notes. The Company has not obtained extensions and waivers from its debt holders beyond March 31, 2001 but is in the process of negotiating further extensions at this time. On July 31, 1999, the Company obtained a $2.5-million, two-year term loan from Coast Business Credit (The "Coast Term Loan"). The Coast Term Loan bears interest at coast's prime rate plus 2.25%, payable monthly. One third of the principal must be repaid in level monthly payments during the first year of the term, with the remainder due in level monthly payments during the second year of the term. The Coast Term Loan is secured by substantially all of the assets of the parent Company. Effective January 5, 2001 Coast Business Credit drew on the Letter of Credit provided by Simplot as part of the Asset Sale and Term Loan agreement (discussed below). As a result, the debt to Coast Business Credit has been retired and the Company owes Simplot $1.2 million plus interest pursuant to Term Loan Agreement. On January 24, 2000, the Company issued $4.5 million of Senior Secured Convertible Debentures (the "Debentures") and warrants to purchase 356,436 shares of common stock. The Debentures were originally due January 24, 2001 and bear interest at a rate of 7% per annum, which is due quarterly beginning March 31, 2000, and is payable in cash or common stock at our option. In June 2000, the Company reduced the exercise price of the warrants to purchase 356,436 shares of common stock to $1.00 and issued additional warrants to purchase an aggregate of 75,000 shares of common stock with an exercise price of $2.50 per share to the Debenture holders in connection with obtaining the Debenture holders' consent to the Term Loan from Simplot described below. On December 11, 2000, the Company and the Debenture holders entered into Amendment No. 1 of the Debentures Agreement, which called for a modification of the maturity of the Debentures to $1.5 million (plus 10% premium thereon) due on January 24, 2001 and $2.9 million due January 24, 2002. On March 7, 2000, the Company and the Debenture holders entered into Amendment No. 2 of the Debentures Agreement, which called for a closing prior to March 31, 2001 at which the maturity of the Debentures would be modified to $1.5 million (plus a 10% premium thereon) due on March 31, 2001 and $2.9 million due January 24, 2002. On April 26, 2001, the Company issued Amended and Restated Debentures to the holders that were in accordance with these terms. In connection with Amendment No. 2, the Debenture holders were issued additional warrants to purchase 500,000 shares of common stock with an exercise price of $1.10 per share. In addition, as part of the Amendment No. 2, the Company agreed that if the Company did not make the March 31, 2001 payment, the Debenture holders would be entitled to additional warrants to purchase an additional 200,000 shares of common stock with an exercise price of $1.10 per share valued at approximately $305,000; of which $113,000 was charged to interest expense and the remaining $191,000 is debt issuance costs. The Company did not meet the March 31, 2001 payment requirement and is in default under the Debentures. As a result the Company is required to issue the additional 200,000 warrants to the Debenture holders. 10 11 On April 12, 2000, the Company entered into a Term Loan Agreement ("Term Loan") with Simplot. The $3 million Term Loan was paid to the Company in July 2000 and used for working capital purposes. The Term Loan was repaid in the same month, July 2000, from the proceeds of the Asset Sale, described above. The FNB Working Capital Facility contain certain restrictions and limitations on the Company's operations, including restrictions on capital expenditures, sale of assets, lease liabilities, mergers or other forms of business combinations, as well as the prohibition on the payments of cash dividends. The FNB Working Capital Facility also contain certain covenants which require the Company to maintain minimum levels of net worth, working capital and other financial ratios, as defined. As of March 31, 2001, the Company was not in compliance with certain of these covenants. First National Bank provided a waiver of such covenants through March 31, 2001. The Company intends to finance its future operations and growth through a combination of product revenues, borrowings available under lines of credit and public or private debt or equity financing. During 2001, the Company also intends to sell or lease all of the BioJect system units it presently has in service to the end user. This change in strategy will increase cash flows from operations over the previous method of renting the BioJect system units. There can be no assurance that Eco Soil will be successful in selling the BioJect system units or in obtaining additional financing on acceptable terms or at all, which would result in a material adverse effect on the Company's ability to meet its business objectives and continue as a going concern. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company's foreign sales are principally to Mexico. All foreign transactions are denominated in U.S. dollars; therefore, the Company's exposure to foreign currency fluctuations is minimal. The Company's working capital facility with First National Bank is based on the prime rate of interest. A 200 basis point change in the prime rate of interest for one year would change the interest the Company would pay on the $5.2 million loan balance of $104,000 per year. 11 12 PART II OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS On March 12, 2001, an arbitrator formally ruled on an arbitration case between the Company and John C. Wells, William Wells and John Pothoff ("former owners") of Agricultural Supply, Inc., which was purchased by the Company in 1998. The result of the arbitration was that the Company was awarded an indemnification of $465,000 for uncollectible receivables included in the assets purchased from the former owners. However, the former owners were awarded an earn-out for the fiscal year 1999 of $449,000. The earn-out will be paid by offsetting it with the indemnification, plus a combination of cash and Company Common Stock. The earn-out is classified as an adjustment to the purchase price, effective January 1, 2000. From time to time, the Company is involved in legal proceedings, claims and litigation arising in the ordinary course of business, the outcome of which, in the opinion of management, would not have a material adverse effect on the Company. ITEM 3. DEFAULTS UPON SECURITIES The Company is in default under the FNB Working Capital Facility. The FNB Working Capital Facility matured as of December 31, 2000. On March 21, 2001 the Company entered into a Change in Terms Agreement with FNB that extended the working capital facility to March 31, 2001 and waived the covenant violations as of December 31, 2000. The Company has not obtained extensions and waivers from FNB beyond March 31, 2001. The FNB Working Capital Facility is due and payable in full. The total amount outstanding is approximately $5.2 million. The Company also is in default under the terms of the Debentures. On March 7, 2000, the Company and the Debenture holders entered into Amendment No. 2 of the Debentures Agreement, which called for a closing prior to March 31, 2001 at which the maturity of the Debentures would be modified to $1.5 million (plus a 10% premium thereon) due on March 31, 2001 and $2.9 million due January 24, 2002. On April 26, 2001, the Company issued Amended and Restated Debentures to the holders that were in accordance with these terms. In connection with Amendment No. 2, the Debenture holders were issued additional warrants to purchase 500,000 shares of common stock with an exercise price of $1.10 per share. In addition, as part of the Amendment No. 2, the Company agreed that if the Company did not make the March 31, 2001 payment, the Debenture holders would be entitled to additional warrants to purchase an additional 200,000 shares of common stock with an exercise price of $1.10 per share. The Company did not meet the March 31, 2001 payment requirement. As a result, at March 31, 2001, the Company's obligations under the Debentures had accelerated and the Debentures were due and payable in full. On April 26,2001, in conjunction with the issuance of the amended and restated Debentures, the Company cured the default. The total amount outstanding is approximately $4.0 million. The Company also is required to issue the additional 200,000 warrants to the Debenture holders. The Company also is in default for failure to pay the Notes and the Simplot Term Loan as a result of the blockage of payments imposed by the FNB Change in Terms Agreement. As a result, the Notes and the Simplot Term Loan are due and payable in full. The total amount outstanding under the Notes is approximately $900,000 and the total amount outstanding under the Simplot Term Loan is approximately $1.2 million. Simplot has the right to offset amounts owed to Eco Soil under product supply agreements against amounts owed by Eco Soil to Simplot under the Term Loan Agreement. Simplot currently owes Eco Soil amounts in excess of the total amount outstanding under the Term Loan Agreement. The Company is currently seeking waivers of the defaults described above and is engaged in negotiations to obtain a new working capital facility. ITEM 5. OTHER INFORMATION FACTORS THAT COULD AFFECT FUTURE PERFORMANCE This report contains certain forward-looking statements about the business and financial condition of the Company, including various statements contained in "Management's Discussion and Analysis of Financial Condition and Results of Operations." The actual results of the Company could differ materially from any forward-looking statements contained herein. The following information sets forth certain factors that could cause the actual results to 12 13 differ materially from those contained in the forward-looking statements. For a more detailed discussion of the factors that could cause actual results to differ, see "Item 1: Business -- Factors That Could Affect Future Performance" in the Company's Form 10-K for the fiscal year ended December 31, 2000. We are in default under our principal debt arrangement, have an indispensable need for capital, and the report of our independent accountants accompanying our financial statements contains an explanatory paragraph regarding our ability to continue as a going concern. Primarily because of our history of operating losses and because of our need to refinance our working capital line of credit with the First National Bank of San Diego, there is substantial doubt about our ability to continue as a going concern unless we are able to obtain additional debt and/or equity financing. We anticipate that without additional financing we would likely run out of cash to fund our operations during the second quarter of 2001. On June 30, 1999 the Company's wholly owned subsidiary Agricultural Supply, Inc. entered into a credit agreement with First National Bank (the "FNB Working Capital Facility"). The FNB Working Capital Facility is a $10 million, three-year credit facility based upon Agricultural Supply's eligible inventory and receivables and has an interest rate of prime plus .25%. Effective June 1, 2000, the following changes were made to the terms of the FNB Working Capital Facility: (a) fixed assets (BioJect(R) system units) were added to the description of collateral, (b) maturity date changed to December 31, 2000, (c) interest rate was changed to Prime plus 1.5%, and (d) personal guarantees were provided by key executives. As of March 31, 2001, of the $6.5 million availability (based on eligible receivables, inventory and fixed assets) under the FNB Working Capital Facility, Agricultural Supply had borrowed $5.2 million. On March 21, 2001 the Company entered into a Change in Terms Agreement with FNB that extended the working capital facility to March 31, 2001 and waived the covenant violations as of December 31, 2000. The Change in Terms Agreement further prohibits the Company from making any payments to subordinated debt holders, thereby putting the Company in default under its Term Loan Agreement with J.R. Simplot Company, its Convertible Subordinated Debentures and its Amended Senior Subordinated Notes. The extension provided by the Change in Terms Agreement expired on March 31, 2001. On December 11, 2000, the Company entered into Amendment No. 1 to the Convertible Debentures and Warrants Purchase Agreement pursuant to which the Company sold the Convertible Subordinated Debentures, which amendment called for the extension of the maturity of a portion of the debentures to January 24, 2002. On March 7, 2001, the Company entered into Amendment No. 2 in which the Company agreed to repay in cash $1,500,000 in principal plus a 10% premium required under the terms of the Convertible Subordinated Debentures on or before March 31, 2001. In connection with Amendment No. 2, the Company issued warrants to purchase 500,000 shares of the Company's common stock with an exercise price of $1.10 per share to the holders of the Convertible Subordinated Debentures. Amendment No. 2 further provides that if the $1.5 million principal repayment is not made on or before March 31, 2001, the Company must issue warrants to purchase an additional 200,000 shares at the same $1.10 strike price and seek to enter into an additional extension agreement. The Company did not make the payment on March 31, 2001. As a result, the Company is in default under the Convertible Subordinated Debentures and is required to issue the additional 200,000 warrants to the holders of the Convertible Subordinated Debentures. We can give you no assurances that the Company will obtain additional extensions and waivers from FNB, the holders of the Convertible Subordinated Debentures or its other debt holders. We currently do not have any arrangements to obtain other sources of financing. There can be no assurance that Eco Soil will be successful in obtaining additional financing on acceptable terms or at all, which would result in a material adverse effect on our ability to meet our business objectives and continue as a going concern. The report of independent accountants on our December 31, 2000 financial statements included herein includes an explanatory paragraph to this effect. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources" and Note 1 of our Consolidated Financial Statements. We have a history of operating losses and an accumulated deficit, and we may not achieve or maintain profitability in the future. At March 31, 2001, we had an accumulated deficit of $50.2 million. We have historically experienced losses due to significant expenditures for product development, sales, marketing and administrative costs, as well as amortization costs associated with our acquisitions of turf and agricultural products dealers. If we are unable to successfully enter new markets, our business will be adversely affected. Sales of our proprietary products remain in the early stages of market introduction and are subject to the risks inherent in the commercialization of new product concepts, particularly with respect to agricultural applications. There can be no assurance that our efforts to increase sales of proprietary products to turf and agricultural crop and ornamental markets will prove successful, that marketing partnerships will be established and will become successful, or that our intended customers will purchase our systems and products instead of competing products. In addition, there 13 14 can be no assurance that we will be able to obtain significant customer satisfaction or market share with our proprietary products. Furthermore, the Company has begun selling Biojects to the end user, this is a new strategy and there can be no assurance that the Company will be successful with this new strategy. The market price of our common stock has fallen below the level required for continued listing on The Nasdaq Stock Market, and we may be delisted. As of March 28, 2001 our stock price had been less than $1 for 30 consecutive trading days, putting the Company in violation of Nasdaq qualification standards for continued listing. The Company has been notified by Nasdaq that it has until July 2, 2001 to raise its stock price above $1 for 10 consecutive trading days or be subject to de-listing following a de-listing hearing. We cannot give you any assurances that the Company's stock price will increase above $1 or, if not, that the Company will prevail in its de-listing hearing and thereby be able to avoid de-listing from the Nasdaq National Market. If Nasdaq were to delist our common stock, it would reduce the level of liquidity currently available to our stockholders. If our common stock were delisted, the price of the common stock would, in all likelihood, decline. In addition, it would be an event of default under our Convertible Subordinated Debentures if our shares were delisted from Nasdaq. If our common stock is delisted from the Nasdaq National Market, we could apply to have the common stock quoted on the Nasdaq SmallCap Market. The Nasdaq SmallCap Market has a similar set of criteria for initial and continued quotation. We may not, however, meet the requirements for initial or continued quotation on the Nasdaq SmallCap Market. If we were not able to meet the requirements of the Nasdaq SmallCap Market, trading of our common stock could be conducted on an electronic bulletin board established for securities that do not meet the Nasdaq SmallCap Market listing requirements, in what is commonly referred to as the "pink sheets." We are dependent on sales to J.R. Simplot Company. On July 28, 2000, we completed the sale of substantially all of the assets of our Turf Partners subsidiary to the J.R.Simplot Company (the "Asset Sale"). In connection with the Asset Sale, we entered into two distribution agreements with Simplot. In the first agreement, a Distribution and License Agreement, Simplot agreed to purchase and distribute a minimum of $5 million of the Company's proprietary FreshPack products during the first two years of the five-year agreement. In the second agreement, Simplot agreed to distribute our proprietary products in Simplot's Soilbuilders stores. We and Simplot also entered into a field trials agreement pursuant to which Simplot will pay us to perform Field Trials of the Company's BioJect system and microbials on selected Simplot crops in 2001. Since the Asset Sale, our revenues have been concentrated on sales to Simplot. Simplot distributes our products in the upper Midwest, Northeast and Southwest. For the fiscal year 2000, sales to Simplot accounted for 11% of revenues, and we expect sales to Simplot to comprise a significantly greater percentage of our sales during 2001. As a result, any reduction in purchases by Simplot for any reason or delay in payment of amounts owed to us by Simplot for product would have a material adverse effect on our business and results of operations. If we fail to manage growth effectively, our business may suffer. Our ability to manage future growth, should it occur, will require us to implement and continually expand operational and financial systems, recruit additional employees and train and manage both current and new employees. In particular, our success depends in large part on our ability to attract and retain qualified technical, sales, financial and management personnel. We face competition for these persons from other companies, academic institutions, government entities and other organizations. We can give you no assurance that we will be successful in recruiting or retaining personnel of the requisite caliber or in adequate numbers to enable us to conduct our business as we propose to conduct it. We may need to raise additional capital that may not be available when needed. The continuing commercialization of our products requires the commitment of significant capital expenditures. We anticipate that we will require additional funds to support the rigorous testing of our products, other costs of obtaining government approval and for marketing of our products for agricultural applications. We anticipate that we will seek to obtain additional funds in the future through public or private equity or debt financing, collaborative or other arrangements with corporate partners or from other sources. We can give you no assurance that we will be able to obtain this additional financing on desirable terms, or at all. If additional funds are not available, we may be required to curtail our operations and marketing efforts in certain geographic areas or for one or more of our product lines. Patents and other proprietary rights provide uncertain protection of our proprietary information and our inability to protect a patent or other proprietary right may impact our business and operating results. Our success will depend in large measure upon our ability to obtain and enforce patent protection for our proprietary products, maintain confidentiality of our trade secrets and know-how and operate without infringing upon the proprietary rights of third parties. We have been granted three U.S. patents for the technology relating to the BioJect system. We do not have foreign patent protection with respect to the claims covered by the two U.S. patents issued in 1993, and we are precluded from obtaining these foreign rights due to the expiration of the period for filing such claims. However, in 14 15 connection with a U.S. patent granted in 1995, we applied for foreign patent protection with respect to the BioJect system in selected countries. To date, we have successfully patented the technology relating to the BioJect system in several of these foreign countries. In addition, we have registered a number of trademarks we use in our business, including "BioJect" and "Fresh Pack" and have applied for registration of a number of additional trademarks. We also rely on trade secrets and proprietary know-how. We generally enter into confidentiality and nondisclosure agreements with our employees and consultants and attempt to control access to and distribution of our confidential documentation and other proprietary information. Despite the precautions described above, it may be possible for a third party to copy or otherwise use our products or technology without authorization, or to develop similar products or technology independently. We can give you no assurance that our patent or trademark applications will be granted, that the way we protect our proprietary rights will be adequate or that our competitors will not independently develop similar or competing products. Furthermore, there can be no assurance that we are not infringing other parties' rights. If any of our patents are infringed upon or if a third party alleges that we are violating their proprietary rights, we may not have sufficient resources to prosecute a lawsuit to defend our rights. In addition, an adverse determination in any litigation could subject us to significant liabilities to third parties, require us to seek licenses from or pay royalties to third parties or prevent us from manufacturing, selling or using our products, any of which could have a material adverse effect on our business, financial condition and results of operations. Even if we prevailed in litigation to protect our intellectual property rights, this litigation could result in substantial costs and diversion of resources and could have a material adverse effect on our business, financial condition and results of operations. We depend on third party contract manufacturers and suppliers. We currently do not have any manufacturing capability and rely on third parties to manufacture our products and components. We have more than one supplier for the manufacture of most of our products and components; however, we obtain some products or components from only one source. Although we believe that we will be able to contract production with alternate suppliers, we can give you no assurance that this will be the case or that the need to contract with additional suppliers will not delay our ability to have our products and components manufactured. We can give you no assurance that existing or future manufacturers will meet our requirements for quality, quantity and timeliness, and any such failure could have a material adverse effect on our business, financial condition and results of operations. We may be unable to acquire rights to additional microbial products. We plan to obtain the rights to additional microbial products. We currently do not engage in our own research and development with respect to the discovery of microbial products. As a result, we seek to license or acquire rights to microbial products discovered by others. We can give you no assurance that we will be successful in obtaining licenses for, or otherwise acquiring rights to, additional microbial products on terms acceptable to us, or at all. If we fail to acquire rights to additional products our business, financial condition and results of operations could be materially adversely affected. Potential product liability or environmental claims could adversely affect our financial condition and results of operations. We may be exposed to product liability or environmental liability resulting from the commercial use of our products. We currently carry liability insurance, which covers, among other things, product liability and environmental liability. A product liability, environmental or other claim with respect to uninsured liabilities or in excess of insured liabilities could have a material adverse effect on our business, financial condition and results of operations. We have obtained insurance of such types and in such amounts as we believe is necessary, including casualty insurance and workers' compensation insurance. However, we are exposed to certain risks that are not covered by our insurance policies and our policies are subject to limits, exceptions and qualifications. Consequently, we can give you no assurance that any losses will be covered by insurance, that any covered losses will be fully insured against or that any claim we make will be approved for payment by the insurer. We are subject to environmental liability. The federal government and some states have laws imposing liability for the release of fertilizers and other agents into the environment in certain manners or concentrations. Such liability could include, among other things, responsibility for cleaning up the damage resulting from such a release. In addition, the federal Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), commonly known as the "Superfund" law, and other applicable laws impose liability on certain parties for the release into the environment of hazardous substances, which might include fertilizers and water treatment chemicals. We also are subject to certain other federal environmental laws, including the National Environmental Policy Act, the Toxic Substance Control Act, the Resource Conservation and Recovery Act, the Clean Air Act and the Clean Water Act and their state equivalents and may be subject to other present and potential future federal, state or local regulations. As noted above, we maintain insurance for environmental claims which might result from the release of 15 16 our products into the environment, but there can be no assurance that any losses covered by insurance will be adequately covered. Thus, a claim for environmental liability could have a material adverse effect on the Company's business, financial condition and results of operations. Our products are subject to governmental regulations and approvals. We are subject to laws and regulations administered by federal, state and foreign governments, including those requiring registration or approval of fertilizers, pesticides, water treatment products and product labeling. Some of our current products are subject to regulation by the EPA, the USDA and by certain state environmental and agricultural departments. Prior to 1998, we had only one registered pesticide with the EPA, Bacillus thuringiensis, and had marketed it as well as other microbial products only as soil inoculants. In 1998, we received two EPA approvals. First, we registered Pseudomonas aureofaciens TX-1 (Spot-less) with the EPA as a biofungicide for use in turf across the United States and received EPA approval of the BioJect as a means of application of the microbe. Second, we received EPA approval to use Xanthomonas campestris pv poaannua (Xpo) as a bioherbicide in experimental use permit trials for use in turf across the United States. We are in the final process of receiving EPA approval on Pseudomonas Hororaphis, Strain 63-28 (AtEze) for use as a biofungicide on greenhouse and agricultural plants. We can give you no assurance that we will obtain EPA approval for sales of additional microbial products as biopesticides. In order to market a microbe as a pesticide, we must obtain EPA approval of a particular product containing that microbe, including EPA approval of the claims made in the product label and the method of application. Registration of our microbial products as pesticides likely will be a lengthy and expensive process that may or may not result in EPA approval. Without the desired EPA approvals, we will not be able to market such unregistered microbes as pesticides, and our sales efforts will be limited to discussions of the soil inoculant features of the microbe. If the EPA determines that a microbial product has no significant commercially valuable use other than use as a pesticide, however, we will be precluded from selling the product entirely unless it is approved by the EPA. In addition, if we intend to sell a microbe as a pesticide for use on crops, we must also seek to have a tolerance level set by the EPA which would define the acceptable limit on the amount of microbes that could be present on a given raw agricultural commodity (food crop) at the time of harvest. We also may petition the EPA for tolerance exemptions that would not limit the residues of the microbial products on crops. If the EPA does not issue a tolerance exemption, we would be required to obtain a separate tolerance for each food product on which we intend to make our microbial pesticides available for use. As a result, we would incur costly application fees for each tolerance. We can give you no assurance that we will be successful in seeking such tolerances or tolerance exemptions, and any failure to obtain such tolerances or exemptions would prevent us from selling microbes as pesticides for use on crops. We may be subject to regulation in foreign countries. Compliance with such requirements likely would result in additional cost to us and delays in introducing our products in such foreign countries. Compliance with EPA and state environmental regulations as well as other laws and regulations will increase our costs and time necessary to allow us to operate successfully and may affect us in other ways not currently foreseeable. In addition, more stringent requirements for regulation or environmental controls may be imposed, which could have a material adverse effect on our business, financial condition and results of operations. The industry in which we compete is extremely competitive and if we are not able to compete effectively our business may suffer. The BioJect system and our Fresh Pack products compete against traditional chemical insecticides and fungicides, chemical soil penetrants, acid injection systems and the direct, manual application of cultured microbial products. Many of our competitors have substantially greater financial, technical and personnel resources than we do. Our competitors include such well-established companies as Novartis Corporation, Rhone-Poulenc AG Company, the Dow Chemical Company, O.M. Scotts & Sons, Inc., Lesco, Inc., and The Toro Company, as well as a number of smaller local and regional competitors. We compete against traditional technologies on the basis of our delivery mechanism and bioaugmentation expertise. We believe that the long-term competitiveness of the BioJect system may be affected by the timing and extent of our penetration into golf and agricultural markets compared to the market penetration achieved by companies offering competing products for microbial distribution. This timing, in turn, will be based on the effectiveness with which we or the competition can complete product testing and approval processes and supply products to the marketplace. Competition among microbial distribution products is expected to be based on, among other things, product effectiveness, safety, reliability, cost, market capability and patent protection. In markets for traditional chemical products, we compete against well-established distributors of such products. Many of these competitors have substantially greater financial, technical and personnel resources than us and include such companies as Lesco, Inc., Terra Companies, Inc., Con-Agra, Inc. and Wilbur-Ellis Company. We compete with 16 17 distributors of traditional chemical products on the basis of price, name recognition, convenience and customer service. Our business is dependent in large part upon the growth and continued popularity of golf. Although we believe that golf markets will continue to grow, a decrease in the number of golfers, reduced participation rates or reduced consumer spending on golf could have a material adverse effect on our golf course customers and, in turn, on us. Specifically, the success of efforts to attract and retain members at private country clubs and the number of rounds played at public golf courses historically have been dependent upon discretionary spending by consumers, which may be adversely affected by general and regional economic conditions. In addition, the construction of additional golf courses is dependent upon growth in the number of golfers. If customer tastes or economic conditions cause golf courses to reduce their budgets or slow the development of additional golf courses, we may see a correlative decrease in sales of the BioJect system and our other products. Our efforts to sell our proprietary products for use in micro irrigation and greenhouse applications might not prove successful. We recently have begun selling our proprietary products to growers who will apply them to crops using micro irrigation methods. Our proprietary products have not been widely applied using micro irrigation methods or in greenhouses and we may not achieve significant market share in these markets. We cannot provide any assurances that our revenues from sales of our proprietary products for application using micro irrigation methods or in greenhouses will exceed the sales, marketing and development costs we have incurred in an effort to penetrate these markets. Our efforts to sell our products outside the United States have had limited success to date and may not be successful in the future. We have devoted substantial resources to developing markets for our products outside the United States, particularly in Mexico where the Company has significant receivables, inventory and fixed assets held in the name of its subsidiary Agricultural Supply de Mexico. In addition, our strategic relationship with The Cargill Corporation calls for us to sell our proprietary products to the Canadian market. To date, our operations outside the United States have generated limited revenues, which have not been sufficient to cover our costs in seeking to penetrate foreign markets. While we are continuing to explore opportunities to sell our products outside the United States, we can give you no assurance that we will be successful. Our international sales efforts are subject to risks associated with operations in foreign countries that may increase our costs, lengthen our sales cycle and require significant management attention. These risks include: o fluctuations in currency exchange rates, which may make our products more expensive; o general economic conditions in international markets; o political risks; o additional costs of compliance with local regulations, including costs associated with unexpected changes in regulatory requirements resulting in unanticipated costs and delays; o tariffs, export controls and other trade barriers; and o longer accounts receivable payment cycles and difficulties in collecting accounts receivable. The costs related to our international operations could adversely affect our operations and financial results in the future. Our stock price has been and will continue to be volatile. Our common stock currently is quoted on the Nasdaq National Market. The market price of our common stock could be subject to significant fluctuations in response to operating results and other factors. In addition, the stock market in recent years has experienced extreme price and volume fluctuations that often have been unrelated or disproportionate to the operating performance of companies. These fluctuations, as well as general economic and market conditions, may adversely affect the market price of our common stock. In addition, in the event the listing of the common stock were discontinued for any reason, the liquidity and price of our common stock would be adversely affected. Our operating results may fluctuate significantly, and any failure to meet financial expectations may disappoint securities analysts or investors and result in a decline in our stock price. Our operating results vary from quarter to quarter as a result of seasonality and various factors. Virtually all of our customers are located in the Northern Hemisphere and purchase greater quantities of microbes and distributed products during the spring, summer and fall 17 18 months. As a result of low customer activity during the winter, we typically market the BioJect system during the fourth and first quarters. As a result of these marketing efforts, we typically receive orders during the first and second quarters and install BioJect systems during the second and third quarters. BioJect revenues generally occur in the second and third quarters of the year. Because of this sales cycle, we expect to recognize a significant portion of our revenues during our second and third quarters. Operating expenses have tended to be independent of the quarterly sales cycle. As a result, operating expenses generally represent a higher percentage of sales in the first and fourth quarters as compared to the second or third quarters, and we may experience losses in the first and fourth quarters. Accordingly, results for any quarter are not necessarily indicative of results for any future period. The sales cycle for the BioJect system also makes it difficult to predict the number of BioJect systems that will be employed and the quantity of microbial products that we will sell until we receive orders during the first half of the year. Sales of our products also depend to some extent on the severity of weather patterns in the geographic areas we serve. Given these factors, it is difficult for us to accurately predict the level of demand for our products. It is likely that in one or more future quarters our financial results will fall below the expectations of analysts and investors. If this happens, the trading price of our common stock would likely decrease. Many of the factors that cause our quarter to quarter financial results to be unpredictable are largely beyond our control. Loss of key personnel could hurt our business. We are dependent upon the active participation of William B. Adams, the chairman of our board of directors and our chief executive officer. The loss of the services of Mr. Adams could have a material adverse effect upon our business, financial condition and results of operations. We do not have an employment agreement with Mr. Adams. We can give you no assurance that Mr. Adams will continue to be employed by the Company. A small number of shareholders may be able to exercise effective control over us. As of March 31, 2001, our current principal shareholders and management owned more than 14% of the outstanding shares of our common stock, assuming the exercise of all outstanding options and warrants held by them and no exercise of options or warrants held by others. Accordingly, even though we currently have cumulative voting, the current principal shareholders and management, if voting in concert, may have the ability to effectively control the election of a majority of our directors or any other major decisions involving our assets or us. Anti-takeover provisions of our charter and Nebraska law could limit the ability of another party to acquire us, which could cause our stock price to decline. Certain provisions of our articles of incorporation, including provisions creating a staggered board of directors, and certain provisions of Nebraska law, including the Nebraska Shareholders Protection Act, could have the effect of deterring or delaying a takeover or other change in control of Eco Soil, could deny shareholders the receipt of a premium on their common stock and could result in a decline in the market price of our common stock. In addition, our board of directors is authorized, without any action by our shareholders, to issue up to 5,000,000 shares of authorized but undesignated preferred stock and to fix the powers, preferences, rights and limitations of this preferred stock or any class or series thereof. Persons acquiring preferred stock could have preferential rights with respect to voting, liquidation, dissolution or dividends over existing shareholders. 18 19 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K. Exhibits: 3.1(3) Amended and Restated Articles of Incorporation 3.2(4) Articles of Correction to Amended and Restated Articles of Incorporation 3.3(5) Articles of Amendment to Amended and Restated Articles of Incorporation 3.4(3) Bylaws, as amended 4.1(2) Form of the Common Stock Certificate 10.1(6) Amendment No. 2 to the Convertible Debentures and Warrant Purchase Agreement, dated as of March 7, 2001, among Eco Soil Systems, Inc., Agricultural Supply, Inc., Sistemas Y Equipos Agricolas, S.A. de C.V. and Agricultural Supply de Mexico, S.A. de C.V. (including Form of Amended and Restated 7% Senior Secured Convertible Debenture). 10.2(6) Stock Purchase Warrant (with schedule of warrant holders) 10.3(1) Change in Terms Agreement, dated March 21, 2001, among Agricultural Supply, Inc., a Delaware corporation, Eco Soil Systems, Inc., Agricultural Supply de Mexico, S.A. de C.V., Sistemas Y Equipos Agricolas, S.A. de C.V. and First National Bank.

---------- (1) Filed herewith (2) Incorporated by reference to the Company's Registration Statement on Form SB-2 (File No. 333-15883) filed with the Commission on November 8, 1996. (3) Incorporated by reference to Amendment No. 4 to the Company's Registration Statement on Form SB-2 (File No. 333-15883) filed with the Commission on January 16, 1997. (4) Incorporated by reference to the Company's Registration Statement on Form SB-2 (File No. 333-39399) filed with the Commission on November 4, 1997. (5) Incorporated by reference to Amendment No. 1 to the Company's Registration Statement on Form SB-2 (File No. 333-39399) filed with the Commission on November 21, 1997. (6) Incorporated by reference to the Company's Annual Report on Form 10-K (File No. 001-21975) filed with the Commission on April 18, 2001. (b) REPORTS ON FORM 8-K None. 19 20 SIGNATURES In accordance with the requirements of the Exchange Act, the Registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Eco Soil Systems, Inc. Date: May 15, 2001 By: /s/ WILLIAM B. ADAMS ------------------------------- William B. Adams Chairman and Chief Executive Officer Date: May 15, 2001 By: /s/ JOHN LOMORO ------------------------------- John Lomoro Chief Accounting Officer 20

ECO SOIL SYSTEMS INC 10-Q